The future

Shift towards sustainable financial service delivery

The strengths and weaknesses of the PMO model need careful analysis. It is true that, in the absence of more mature local-level financial institutions, the PMO-administered credit lines have satisfied a need. It is also true that the users (borrowers) of the credit disbursed by PMOs may put a premium on accessing credit and be less concerned about their ability to pay back. In this context, one particular weakness in the PMO model stands out. It is inherent in all project administered credit lines, and is not unique to China. Government officials who administer credit can rarely acquire the information necessary for proper appraisal of clients and their proposed ventures. For a proper review of loan applications, they need information from local informal networks about clients' suitability to reduce the risk of low recovery and of bad debts. In technical literature, limited access to such data is termed 'information asymmetry'. On the other hand, such knowledge is held by local informants or obtained when systems are used for peer review of credit applications. Local financial institutions that operate at the township, county and community levels build up such information. The PMO model of credit delivery using the Finance Offices does not form part of the local financial infrastructure: PMOs have limited access to reliable information for assessing and reducing risk. Errors in loan appraisals are thus more likely to arise and the probability of bad debts and low loan recovery increases.

In China, RCCs are the necessary entry point into the local financial infrastructure. The overall financial activity in the rural areas originates from the RCCs and returns to them. Apart from helping integration with the local financial infrastructure, a shift to the RCC model has two distinct advantages. First, given the evidence of the huge demand for credit in the rural areas of China, no donor will be able to satisfy such demand by adopting solutions that are institutionally non-sustainable.

Donors should, instead, consider using funds to leverage local resources in order to develop local financial infrastructure capable of shifting from traditional to poverty-focused lending. The efficiency gains that could be captured by leveraging local resources or unshackling part of the local resources for poverty alleviation are immense. For example, the Jiangxi/Ganzhou Integrated Agricultural Development Project covers 47 townships. Using the PMO model of credit delivery, CNY 193 million are to be allocated for five years. The annual credit disbursement is estimated at about CNY 39 million. In contrast, total savings for all the RCCs involved were found to be not less than about CNY 380 million (each RCC in the project area had an outstanding savings balance of approximately CNY 8 million). Were IFAD projects able to leverage only 10% of these funds for microfinance every year, the allocation for credit would double.

The second advantage is that the management information system of the local financial infrastructure is generally well developed compared with that of non-financial institutions. The former are transparent with regard to utilization of funds and under the supervision of the Central Bank.

These reasons rightly prompted IFAD to move towards use of RCCs. In addition, the Government has also realized the importance of integrating credit services with those of the local financial infrastructure. It has issued guidelines prohibiting all credit-related activities through government departments. IFAD was the first IFI to experiment with integrating project-funded credit operations with those of RCCs. As with any first effort, it has not been without difficulties but what is positive is that lessons are being learned.

The findings of the present study were presented at a Technical Review Workshop in Beijing in July 2000, the aim being to: (i) disseminate study findings; (ii) arrive at a common understanding of issues confronting the implementation of credit components under IFAD projects; and (iii) reach broad agreement on future action. Details of the workshop are provided as Annex 6 of the main report. The recommendations set out below are broadly in line with the workshop deliberations.

Overall RCC reform

Developing management capabilities

Depending on the direction that the RCC network takes in the future, two broad recommendations emerge. First, RCCs could be transformed into small, joint-stock single-unit banks, probably with much-reduced minimum capital and other licensing requirements; the related governance issues would need to be addressed in the framework of the existing commercial banking law. A second possibility is that the RCCs develop as genuine cooperative banks. To that end, an internal management structure with apex organizations at different levels would need to be developed for management support, training, audit and supervision.

For the second course of action, it is imperative that the demand for apex-level structures should be mobilized from, and driven by, the primary level RCCs. Otherwise, a supply-driven institution-building approach will too easily appear, with limited efficiency and expensive recurrent cost implications for the RCC network. The latter alternative must be avoided at all costs.

Specialized legal framework?

It is uncertain whether RCCs will emerge as thrift-and-credit cooperatives, cooperative banks or single-unit joint-stock banks. For the last-named option, no specialized legislation would be required as joint-stock banks are fully and entirely covered by national banking legislation. For the first two - cooperative - options, those carrying out reforms should draw upon the expertise of leading modern cooperative associations with extensive experience in legal matters, such as the Raffeisen Foundation in Germany. Desjardins International Development is another source of detailed knowledge in facilitating microcredit operations.

Savings-based development approach

Deposit instruments need to maintain their current range of term diversification and pricing. RCCs have had a higher proportion of deposits from households and a higher proportion of time deposits. Moreover, the proportion of time deposit to household deposits was around 70% compared with 55% for ABC. Compulsory deposit insurance available to rural depositors in RCCs and ABC instead of a de facto state guarantee for state-owned financial institutions would diversify risks and increase the robustness of the financial system.

Transparency of loan rescheduling

Tracking down rescheduled loans in a bank's portfolio is neither an impossible nor a mysterious undertaking. However, the statement of accounts on which the accounting frame is based needs to be updated. In the 'Loan Assets' heading of the accounts, a separate item for rescheduled loans needs to be added. If loans are rescheduled with different maturities sub-accounts should be inserted, classified by repayment period. To achieve consistency, development projects should avoid putting rescheduling routines in their credit manuals; instead, they should promote adequate loan loss provisions for treating rescheduled past-due loans.

Loan write-off based on an adequately classified loan portfolio

Procedures for asset classification need to be revised. Capital infusions similar to the inflows into SOCBs could be considered after RCCs have been classified into four categories: insolvent, potentially recoverable, operating with problems, and operating satisfactorily. Similarly, the distortions of fictitious income from outstanding loans that have no chance of being recovered can be ameliorated in part by a shift to cash accounting procedures. Inadequately trained and supervised RCC staff may contribute to unwarranted practices, such as inflating loan portfolio size and net incomes.

Strengthening commercial lending capacities

The banking skills of RCC staff need upgrading to a level that will allow for sound financial and elementary technical screening of loan applications. The recent trend to separate policy-based lending from commercial lending is a welcome step. In the longer run, the rural finance system requires a level playing field between the different institutions and the phasing-out of preferential and subsidized lending to priority target groups.

Promoting complementary between non-financial and financial services

Complementarities at the client level should be pursued to avoid an imbalance between loans and technical services through state extension and support services or through innovative ways of promoting small enterprise development. For non-credit financial services, insurance schemes and loan and deposit services have been introduced and are on offer through the Animal Husbandry Bureau for livestock insurance. These would broaden the scope of financial services and encourage a shift from a credit-based approach to a broader service approach.

Improved mechanisms to facilitate learning

There is no harm in not having it right the first time an activity is undertaken, but there is a need for a structured process to be put in place for drawing relevant lessons from past experience and incorporating them into future activities. The onus is on donors to put in place more objective and transparent monitoring and evaluation systems and to make results available to other agencies planning to replicate a service delivery approach. Once this system is in place, the debate will be greatly facilitated. The pros and cons will clearly emerge for the government-staffed parallel financial intermediation structures set up by a number of microfinance projects. Their performance and prospects need to be compared with those of the RCCs that operate within the existing framework of rural financial institutions. Such a broader comparative analysis is beyond the scope of this study. It is, however, recommended that the donor community follow up with a broader, possibly jointly launched, evaluation of rural finance and microfinance approaches in China. Involvement of the different government ministries and agencies would be imperative. Such an objective performance assessment could then guide future decisions regarding support to financial systems.

Design considerations for future IFAD projects

Despite its imperfections, microfinance is still a key element in poverty eradication policies. No one approach can be applied uniformly across all regions of China. In some areas, where no local financial infrastructure exists in the form of RCCs, the PMO model may still be a valid option. In the Chinese context, the limitation of IFAD's loan instrument becomes apparent in mainstreaming IFAD project funds into the local financial infrastructure. It uses only the loan instrument, and volume is small compared with other major IFIs. Using its own resources and instruments, IFAD may not be able to negotiate reform of RCCs, which would be part of the overall financial sector reforms, as well as public sector reform. Issues can be addressed by encouraging RCCs to experiment and by creating a system of rewards and sanctions. The pilot experiments assisted by IFAD ought to be jointly evaluated for replication. This would serve and assist all Chinese partner institutions in learning and reassessing policy.

IFAD loan-use procedures

In China, the system of resource transfer from the central to local governments is unique, with two distinct features. First, IFAD funds are transferred as loans through to the township level, and the township local government is responsible for repayment. In most other countries, IFAD loans either flow as grant funds from the central government or as loan funds only to the level of provincial government. The foreign exchange risk always remains with the central government. The townships receive IFAD loan funds as grants. Second, the provincial, prefecture, county and township governments are responsible for mobilizing the necessary counterpart funds. In most other countries, counterpart funds are provided either by the central government or by the provincial government.

The present system in China for transfers of loans needs to be changed. If funds reach the county and township level as 'loan funds' to be repaid, it is too optimistic to assume that the local governments will hand over funds for the credit component to RCCs. Local governments prefer to retain firm control in their final allocation, since they themselves ultimately have to pay them back. At the same time, funding under projects for rural infrastructure, training and extension services needs to reach the township government as 'grants.' Credit funds should be made available to the RCCs as loans. Funding for capacity building and infrastructure to improve RCC outreach and client access will have to be provided in grant form. Following the theory of 'seeing is believing,' it would be appropriate to organize a study to permit policy-makers in China to study and understand the procedures of IFAD loan use in other countries.

Case for changed MOF regulations on transfers of funds

It is not easy to understand why MOF has one set of regulations for IFAD funds and another set for other IFIs. IFAD funds are transferred to provinces at 4.5% and the provinces have to bear all the risks. In contrast, World Bank funds are transferred to provinces at 2%, or at considerably lower rates. Such disparities need to be minimized. If arrangements similar to those of the World Bank are established, provinces will be able to lend to RCCs at an acceptable interest rate. RCCs, under the IFAD project framework, borrow from the county or township, but it would be appropriate for RCCs to borrow directly from the provinces to avoid co-ownership of funds at the local level. Participants in the above-mentioned Technical Review Workshop also recommended that credit funds be transferred directly from the provinces to RCCs.

Incentives for the RCCs

The main reason for including RCCs in all efforts to improve a given region's financial infrastructure is to encourage them to take an active interest in microfinance. This is not an easy task. RCCs may not readily use any of their sources of refinancing (deposits from clients, refinancing from PBC and loans from other banks) for microcredit operations. Strong, credible incentives are required to convince RCCs to change the way they operate, but getting them interested is particularly difficult given their current situation. Crises in the financial sector have induced PBC to tighten controls under which RCCs and other financial institutions operate. Taking RCCs into account in the design of credit projects and placing them at the centre of the local financial infrastructure is only the first step.

The first issue to be addressed should be the cost at which RCCs receive funding within the IFAD project framework. It has been assumed that the cost of funds for RCCs should cover operational cost and credit risk. However, RCCs need to be provided with funds at attractive costs and terms compared with those of other sources of refinancing but will not reduce the incentive to mobilize deposits. A dependency or 'lock in' to donor funding must be avoided. It would be appropriate that the RCCs receive funding at a rate not exceeding the rate at which PBC lends to RCCs.

Financial intermediation at the local level improves once complementarity among the interlinked elements of the local financial infrastructure is strengthened. This calls for the various civil-society organizations and other actors to collaborate with RCCs in providing credit in rural areas. However, the present financial situation of the RCCs does not allow them to invest in enhancing outreach capability and capacity building, so RCCs require grant funding for these purposes.

Product development

There exists a clear mismatch between the current range of products offered by RCCs, credit instruments designed in IFAD projects, and the products required by resource-poor households. RCC credit instruments have four basic features: (i) they are short-term in nature, repayable within one year; (ii) repayment can be made in one instalment at the end of the repayment period; (iii) interest rates are stipulated by PBC; and (iv) reliance on credit history and collateral of the applicants. IFAD project loans are mostly medium-term, for agriculture and livestock development [see Annex 5 of main report]. Client selection and provision of technical services rest with the PMO and credit delivery with RCC. No collateral is insisted upon and a client's credit history is not normally reviewed. Such shared responsibility has led to RCCs insisting on shifting the credit risk to PMOs. In contrast, most resource-poor households initially require small loans for consumption. With time, their credit absorption capacity should increase and they will be able to develop the necessary credit history to obtain larger loans.

It is essential that RCCs be permitted to design products that meet the requirements of resource-poor households while yielding the required spread to RCCs to cover the cost of funds, transaction costs, credit risk and reasonable profit. The essential features of the microfinance instruments to be built into the IFAD project framework are:

(i) Flexibility in activities for which loans can be provided. Currently IFAD project design stipulates the activities for which funding is available. There needs to be complete flexibility concerning activities for which a loan can be made available. Households should be able to borrow for a broad range of activities, including consumption.

(ii) A ladder approach to develop credit history. RCCs need to focus on developing a credit history for clients by providing small loans initially and allowing clients to graduate to larger loan amounts.

(iii) Pro-poor lending policies. Lending policies such as requirements for collateral and guarantees need to be modified, adopting instead joint liability concepts and credit-history-based lending. RCCs need to move away from 'bullet' repayment practices that lump all payments at the end on the loan period, to more structured weekly or monthly repayment plans.

(iv) Incentive for prompt repayment. The clients need to understand the importance of prompt repayment and the advantages linked to it. The client who has promptly repaid the loan should be able to easily access a larger loan amount. Persons with a better credit history might even be given a discounted interest rate.

(v) Flexible lending rates. RCCs need to be allowed to adjust lending rates to reflect their perception of credit risk, transaction cost and cost of funds.

RCC/PMO collaboration

IFAD projects have attempted to foster collaboration between PMOs and RCCs. The PMOs are responsible for tasks related to client identification and activity selection; the RCCs are responsible for credit delivery and recovery. However, project design gives the RCCs 'imaginary' powers to appraise loan requests and to accept or reject them. Two factors contribute to the inability of RCCs to resist pressures from PMOs and local government. First, the RCCs have limited technical competence to appraise agriculture development activities. Second, the funds are provided by the PMO and the RCCs are obliged to follow PMO instructions.

The most successful credit projects have been those handled directly by one agency without local government interference. Such an agency needs to be a financial institution or an institution with a clear vision of establishing itself as a sustainable financial institution. Unless the funding is routed directly from MOF to the RCCs through their supervisory bodies, it is unlikely that RCCs will be able to act independently and to shoulder the credit risk.

Any meaningful financial service-based rural development effort to reach the resource-poor in China requires a two-pronged approach in IFAD projects. First, the funding track for RCCs needs to be completely delineated, with independence from local government. Grant funding should be provided to RCCs to strengthen their capacity, incorporate the microfinance strategies evolving in China into their regular lending strategies and increase outreach by employing village agents. RCCs should be authorized to select and fund clients using newly developed microfinance strategies. RCCs will have to be encouraged to use funds from their own savings mobilization by providing incentives for microfinance lending, rather than providing funds for lending operations. In the case of RCCs facing liquidity constraints, their access to the PBC refinance window could be enhanced.

Second, the size of the credit components of IFAD projects needs to be substantially reduced. Since the current financial situation of many RCCs may not permit their active involvement in medium- and long-term credit, the capacity of PMO to provide medium- and long-term loans should be enhanced. Systems need to be built to ensure that PMOs do not offer unhealthy competition to the RCCs. The rate of interest on loans should be equal to the yearly interest rate charged by RCCs. The PMOs should be allowed to provide only one loan per client to ensure that they can obtain subsequent loans from the RCCs. Record keeping, loan account monitoring and maintenance of a revolving fund will have to be substantially improved to improve transparency.

Technical Backstopping

The provision of technical services to households continues to be the core competence of various line departments under the umbrella of PMOs set up under IFAD projects. WFP collaboration in the provision of training has helped enhance credit utilization. This arrangement needs to be strengthened with grant funding for PMOs to undertake these activities.

Reaching Those Not Reached by Financial Institutions

For poverty alleviation lending, complete dependence on formal financial institutions such as RCCs is a double-edged sword. One the one hand, it improves efficiency and therefore institutional sustainability is a distinct possibility. On the other hand, it may exclude a set of people who do not possess the necessary credit history and demonstrated ability to effectively use credit. Even with well-intentioned microfinance product design and delivery systems, it would take a long time to develop RCCs as poverty-focused institutions. In addition, there exist areas without local financial infrastructure. A PMO-led strategy for reaching such areas and households remains a valid proposition.

A self-help group (SHG) strategy with groups as the elements of local financial infrastructure is a better option compared with the direct lending strategy adopted by various civil-society organizations. The example of cooperatives in Germany could be borne in mind. A different initiative to create financial services groups came from Asia after World War II. Constituted by banks to group together small borrowers, as in the German example, the Asian groups were also intended to collect savings and distribute credit among themselves.

Financial groups are now well established aspects of the financial infrastructure in many developing countries. In most parts of Asia, SHGs have become channels of microlending operations through systematic links with financial institutions. In Africa, groups have been used in monetization actions and as a channel for microlending operations. The groups perform the core function of risk absorption essential for the development of financial infrastructure. To perform this function more efficiently, the groups need to build equity with member contributions and, when possible, with donor money. The main issue is the need for institutions to take the initiative to create groups.

With their network extending to the village level, and with necessary capacity building, PMOs are best suited to take over the responsibility of group mobilization. The essential features of SHG mobilization in China need to be group mobilization, capacity building, provision of a small revolving fund and subsequent linkage with the RCCs. Collaboration with WFP could be used to help build up the capacity of the groups, improve credit uptake by resource-poor households and, for RCCs, develop a set of new clientele with requisite credit history.